FINS3623

Venture Capital

Week 2 – Private Financing

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Review Questions
 If you had to come up with a textbook definition
of a venture capital fund, what would that be?

 Why do investors allocate funds to private equity

portfolios?

 Does the capital gap arise mainly because

venture capital investments have high risk?

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Lecture Outline
 Sources of Private Firm Financing

 Characteristics of Firms Receiving VC

Investments

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Forms of Financing of Private Firms

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Sources of Finance for Growth Firms

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 Sources of Equity Finance
 Bootstrapping

 Various sources of internal equity:

 Own money, savings, credit cards,
personal loans, second mortgage
 Often a must before any other form
of financing

 The longer the business can sustain

itself and grow via bootstrapping,
the better.

“The slow bootstrap worked really well [for GoPro]… As

long as you can bootstrap not at the sacrifice of
competitive advantage, bootstrapping is a really powerful
thing because it allows you to be totally devoted to your
vision.”

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Sources of Equity Finance
 Why firms should NOT obtain external funds too early?
 The high costs of external finance at early stages

 Incentives to spend, expand and squander

 No opportunity for correcting errors and poor decisions
 Venture capitalists are not that patient
 They want to exit in 5 years
 Outside investors can hinder the entrepreneur
 Outside investors often prefer the safe proven routes learnt from previous
investments, while the entrepreneur may prefer experimental try-it fix-it
approach in an uncertain environment
 By bootstrapping entrepreneur can ensure very high returns
 Conversely, VCs will want too much ownership at early stage = little
incentive/wealth creation for entrepreneur
 Bootstrap capital can be used as a leverage to raise external
funds

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Sources of Equity Finance
 Government Grants & Tax incentives
 R&D tax incentive is the single biggest government program supporting Australian
start-ups and it’s a major funding source.

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Sources of Equity Finance
 Start-ups choose to stay home, SMH, July 24th 2012
 Many startups are praising the govt’s tax credit support for R&D
 An important source of funds:
 "We ran out of the money we raised from investors and had actually had not
reached our development milestones and were actually in a bit of financial
trouble," "What the R&D rebate allowed us to do was spend a few more months
on risky speculative development work, that we really wouldn't get investors to
fund.”
 Can be used as a leverage to obtain external funding
 "If you raise half a million dollars, you can use the tax concession to bring in
more money and make that go further,”
 "The valuations are going to be lower here (Australia) but in some sense the
government grants counter that.
 Tax offset incentives are also available to start-up investors.
 Every dollar invested in a start-up entitles investor to a 20c tax offset.
 Investors are also exempt from capital gains tax for up to 12 years.

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Sources of Equity Finance
 Family and Friends
 The 2nd biggest source of financing for startups

 Typically, invest anywhere between $10,000 and $150,000 of their own

personal finances

 Capital from “family and friends” network may not be subject to the
information and moral hazard problems because of close personal
connection and history with entrepreneur.
 See below my article in The Conversation on this: https://theconversation.com/limiting-
startup-tax-incentives-could-exclude-an-important-group-of-early-stage-investors-
54894
 However entrepreneurs often accept money from such investors without
following the corporate formalities that institutional investors require.
 This can create problems and conflicts down the track.

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 Sources of Equity Finance
 Angel Investors/ Seed Capitalists
 Professional investors investing with their own
funds
 Often wealthy individuals with a lot of experience:
 Investment objectives:
 Reaping the initial high returns by getting in
early
 Reaping returns from value adding activities
 Prepare the company for venture capital
funding
 Market for angel investments (US figures):
 Activity: $12 billion in 2007 => $25 billion
 Average deal size: $342,000 in 2012
 Median investment = $15,000

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Sources of Equity Finance
 Venture Capital

Seed Equity
Series A Pref
Series B Pref
Series C Pref
Series D Pref
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Sources of Equity Finance
 Growth Equity

 Private Equity
 MBO
 MBI

 IPO

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Financing Path to IPO – Uber
 Uber’s pitch to early investors in 2010.

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Financing Path to IPO – Uber

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Financing Path to IPO – Atlassian

Date Amount / Round Valuation Lead Investor Investors

$150M / Secondary $3.15 billion T. Rowe

Apr, 2014 2
Market Price

$60M / Secondary
Jul, 2010 — Accel 1
Market

Source: Crunchbase

Atlassian IPO in 2015 at a valuation of US $4.4bn

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 Atlassian ownership structure at IPO
(IPO value at $4.4 billion, today value $95bn)

Compared to Uber’s ex-CEO Travis

Kalanick 10% ownership of Uber before
selling to Softbank in early 2018
Uber last traded market cap: $78 billion 18
Sources of Debt Finance
 Bank Loans:
 Overdrafts, commitments, term loans, etc.
 Contribute to about 30% of funding of pre-IPO firms
 Difficult to obtain for start-ups as banks require
 Stable cash flows
 Collateral in the form of tangible assets
 Lending without pledgeable cash flows or assets:
 Moral hazard: Borrowers have different risk appetite to lenders
 Adverse selection: substantial information acquisition costs
 Banks face same problems as equity holders, but without the
same contingent returns
 The result is credit rationing (or debt gap)

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Sources of Debt Finance
 More exotic debt financing sources:
 All suitable to later-stage bridge-capital firms
 Mezzanine funds:
 Provide debt financing combined with equity component
 Debt is often in the form of unsecured, long-term and less than
senior-rank instruments
 Venture lending (and leasing)
 Similarly, provides debt financing with some warrant component
 Often provides small debt amount that allows the firm to
continue to operate until the next equity funding round
 Requires the backing/guarantee of existing venture capitalist
 Often requires blanket collateral over all assets

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Characteristics of Firms Receiving VC
Investments

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VC Investment Decision Making

Due
Screening
Diligence to Valuation Successful
based on Financial
Verify and Funding
Qualitative Assumptions
Financial Negotiation Applications
Factors
Assumptions

Rejected Funding Applications

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VC Investment Decision Making
Survey results from Gompers, Gornall, Kaplan and Strebulaev (2020)

Where do deals come from?

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VC Investment Decision Making
What creates value?

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VC Investment Decision Making
Deal funnel

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VC Investment Decision Making
 Constraints in VC decision making
 Scare and incomplete information
 Time
 Market environments and competition from other VCs
 Expertise of partners
 How do VCs optimise their decision making process?
 Assign “sponsoring” or “specialized” partner
 …….. but make decisions as a team (team game)
 and rely as much as possible on external sources of information
 How does this system alleviate the constraints above?

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 Internal Process
1. The deal arrives at the firm and is assigned to a GP
• Usually through a referral, GP usually checks with a second partner
2. The deal becomes active
• Memo is circulated profiling team, market and tech. Specialized
partners ask “What do I need to believe to think this will succeed?”
3. The deal becomes widely know within the firm and attracts
positive sentiment.
• Some due diligence complete, more detailed memo circulated,
decision is pending on resolution of a few outstanding questions.
4. An investment is recommended.
• Investment committee or senior GPs make final decision, or
delegate final decision to assigned GP within certain parameters.

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Survey results from Gompers, Gornall, Kaplan and Strebulaev (2020)

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Analysis of Qualitative Factors

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Criteria for Deciding to Invest
 Internal Factors:
 Quality of Management
 CEO / Team
 Funds at Risk (“Skin in the game”)
 Performance to date (Financial & Non)
 What is the downside of the investment?
 How astute are the co-investors?

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Criteria for Deciding to Invest
 External Factors:
 Market Size & Growth,
 Competition & Barriers to Entry,
 Financial Markets and Exit Conditions

 Difficulty of Execution:
 Product and Technology, Strategy.

 Compare these to the catchwords in the VC

industry:
 Team, markets and products

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Quality of Management
 Examples of Strengths (Cited in 40/67 investments):
 Management team has extensive internet and website management
experience.
 Management team is believed to be good in science, and at raising and
conserving money
 Experienced managers out of successful venture backed company.
 Highly sought-after entrepreneur/founder, who co-founded company that
went public.
 Experienced, proven and high-profile CEO.
 Founder has high marks from existing investors.
 Known CEO for a long time.
 Team has acquired significant level of and relationships in a fairly short
time.
 CEO/founder is capable of attracting necessary employees.
 Has developed excellent product consuming modest amounts of capital.
 CEO is very frugal and will not spend unwisely.
 Founder very committed: quit job at competitor and mortgaged his house.
 Team is well-balanced, young and aggressive.

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Quality of Management
 Examples of Risk/Weaknesses (cited in 41/67 firms).
 CEO is a “rather difficult person.” Active involvement of chairman will be crucial.
 CEO/founder has a strong desire for acquisitions.
 VCs have to devote substantial time evaluate.
 Management has not shown in the past that it can effectively forecast financial
progress.
 Company is in many seemingly disparate businesses; a reflection of management’s
lack of focus?
 Will management be able to integrate acquisitions?
 The CEO’s choice of past companies questionable.
 Management is young and relatively inexperienced.
 Management team is incomplete.
 Company is highly reliant on one individual (the CEO).
 Company needs CEO, CFO, COO, and control (operating, reporting, and billing)
systems.
 Need seasoned industry executive.
 Incomplete management team. A milestone for further funding is hiring VP of sales
and marketing.
 Must strengthen management and ensure involvement of VC as chairman.

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Funds at Risk
 Examples of Strengths (Cited in 13/67 cases).
 Participating preferred protects VC if mediocre
performance.
 Equipment can be funded with debt.
 Investors have ability to control growth.
 Minimize downside by only providing limited funds until
milestones met.
 VC commitment will be invested over time.
 Cash-efficient early stage thanks to future company
acquisitions with stock.
 Can take company to leading industry position with a
minimum of capital.

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Funds at Risk
 Examples of Weaknesses
 Uncertainty about what proper milestones should be.
 Large amount of capital for a start-up enterprise.
 Will require strong management oversight.
 Aggressive bank loan assumptions. Might require either
slower expansion or more equity capital.
 Company has little in the way of underlying asset value and
thus offers limited downside protection.
 Company expects to need additional financing next year.
No assets of value except for employees.
 Need sufficient checks and balances regarding drawdown
of funds.

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Performance to Date

 Examples of Strengths (Cited in 18/67 cases)

 Demonstrated profitability of business model.
 Company has a manageable cash burn rate and is
expected to be cash-flow break-even in 12 months.
 Significant sales growth and momentum.
 Has developed product, well-positioned to achieve revenue
target.

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Performance to Date

 Examples of Weaknesses
 Company is making losses and performing below plan.
 Bad debt problem, which significantly changed the
profitability of the company, because of past business
procedures.

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Market Size and Growth

 Examples of Strengths (Cited in 46/67 cases).

 Large market amenable to rapid growth.
 Two very important and visible market opportunities,
which should both be over $1B with an few years
 Very large market in which incumbents earn high profit
margins.
 Company could dramatically impact the evolution of
the computer industry.

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Market Size and Growth

 Examples of Weaknesses
 Regulatory uncertainty.
 Country risk.
 Currency risk.
 New, largely unproven, marketplace.
 General downturn in industry.

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Competition and Barriers to Entry

 Examples of Strengths (Cited in 22/67 cases)

 Strong proprietary and patent position.
 Company is targeting a significant market segment that is
underserved by incumbents.
 Early mover advantages from being pioneer of concept and
largest player.
 Highly fragmented industry, which makes it for
consolidation.
 No competitors.
 There is more than enough room for several competitors.

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Competition and Barriers to Entry
 Examples of Weaknesses
 Customers might become competitors once they learn
company’s business model.
 Patent protection alone might not provide enough barriers
to entry.
 Many new entrants—price competition could drive down
margins.
 Competitive and tight labor market, competing with larger
established firms for employees.
 New technology might be long-term threat.
 Low barriers to entry. Low switching costs.
 Product can be copied by large entrenched firms.

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Likelihood of Customer Adoption
 Examples of Strengths (Cited in 20/67 cases)
 Conceptual acceptance by professional community.
 Beta arrangements with large customers.
 Solid base of customers.
 Customers are positive regarding the product and the
management team.

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Likelihood of Customer Adoption
 Examples of Weaknesses
 Uncertain whether can convince customers to bet on
an unproven technology.
 Customers may not want to pay enough of a premium
for product.
 Target customers have not historically been speedy
adopters.
 Financial viability of customers and existing contracts
questionable.
 Challenge is to broaden the product beyond the initial
customer segment.

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Product and/or Technology
 Examples of Strengths (Cited in 27/67 cases)
 Late stages of product development (first product launch
planned in 15–18 months).
 Superior technology with large market potential.
 Revolutionary new technology.
 Has developed excellent product.
 Has built a robust, scalable system that can meet he
current market demands.
 Best product on the market.
 Well tested technology/product.
 Early-stage company with post-beta product with
competent/experienced technology team.

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Product and/or Technology
 Examples of Weaknesses
 Outcome of clinical tests and development: Must prove that
technology is superior to other marketed alternatives, in
terms of efficiency and side effects.
 Early stage research project: Project is elegant, ambitious
and, consequently, difficult.
 Ability to make technology work at target cost point.
 No guarantee product will work in a full production
environment.
 Identification and development of a more compelling
product.
 Product scalability is to be fully tested.

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Business Strategy/model
 Examples of Strengths (Cited in 36/67 cases)
 Company significantly reduces costs while maintaining quality.
 Compelling business strategy. Presence or likelihood of validating
corporate alliances.
 Outsourcing means less for company to manage.
 Attractive and demonstrated profitability of business model.
 Excellent new concept.
 Favorable acquisition opportunities, which will be driver of growth.
 Distinctive strategy.
 High value-added, high margin strategy for very little capital upfront.
 “Lean and mean” operation with few employees and good customer
focus.
 Pure play/focused.

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Business Strategy/model
 Examples of Weaknesses
 Real sales effort needs to be mounted, which is very reliant on management
team’s experience to manage profitably.
 Transferability of business model to other markets?
 Are there enough candidates available for acquisition?
 Will company be able to ensure quality while pursuing a growth-through-
acquisition strategy?
 How scalable is the business? Is there any operating leverage in the
business model?
 Lack of focus.
 Vulnerable strategy.
 Execution of business model has yet to be proven.
 Will company be able to attract employees?
 VC due diligence showed that margins and expense percentages of existing
stores have to be brought into line with prototype model.
 Key partnerships not nailed down.
 Geographical risk

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VC Portfolio Fit and Monitoring Costs

 Examples of Strengths (Cited in 12/67 cases).

 VC is strong in this geographic region.
 Adds additional breadth to VC portfolio within this
market segment.
 Good strategic fit with VC.
 VC has board seat on company in complementary
business; marketing partnership possible.

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VC Portfolio Fit and Monitoring Costs

 Examples of Weaknesses
 Complicated legal and financial due diligence needed.
 May require too much time from VC. Geographical
risk—US corporate and overseas R&D.
 VCs have to devote substantial time to evaluate
acquisitions.

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Survey results
Back to Gompers, Gornall, Kaplan and Strebulaev (2020)

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Survey results
Which team qualities matter?

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Experimental evidence
 Bernstein, Korteweg and Laws (JF 2016)
 Is it the jockey or the horse that matters?
 Very early stage ventures are characterised by:
 The founding team
 Traction (Products/Markets etc)
 Current investors
 What matters?
 Human capital: the founders should matter
 Non human capital: the traction should matter
 Information: current investors should matter

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Experimental evidence
 Testing this is hard …
 For example, are serial entrepreneurs more likely to attract
financing due:
 Their past experience
 Because they tend to start companies that look attractive on other
dimensions known to the investor but not to the researcher, such as
the underlying business idea?
 The authors use an experiment using AngelList
 An online platform that matches start-ups with potential investors
 Sends emails to investors featuring start-ups that are raising
capital
 Emails provide specific information on the founding team, the
startup’s traction, and the identity of current investors

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Experimental evidence
 Key findings:
 The average investor is highly responsive to
information about the founding team, whereas
information about traction and current investors does
not lead to a significantly higher response rate
 The most experienced and successful investors react only to
team information
 This suggests that information about the human
capital of the firm is uniquely important to potential
investors, even after controlling for information about
the start-up’s idea

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Summary: What VC’s Look for
 Market
 Advantage People

 Management

 Endorsements Deal

 Capital Required Valuation Market/Product

 Exit/Returns

 History

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